Debt capacity: how much debt your company can really support

"My bank is offering me €600,000 of credit to finance the new production line. Can I actually afford it?" We hear this question constantly, and the honest answer is almost never a flat yes or no. A company's debt capacity is not what the bank is willing to lend. It is what your cash flow can repay comfortably, even in a bad year.

Debt is neither good nor bad in itself. Sized well, it funds growth without diluting your equity and lifts the return on the capital you have invested. Sized badly, it turns a routine dip in activity into a liquidity crisis. The whole game is knowing where your prudent limit sits. Here is how we work it out.

The right starting point: EBITDA, not net profit

Debt capacity is built from EBITDA, the operating result before interest, taxes and depreciation. Why not net profit? Because EBITDA is the closest proxy for the cash the business actually generates to service its debt. But it has to be normalized first. Strip out one off items, bring your own pay back to a market level, and remove anything that will not recur. An EBITDA flattered by an artificially low owner's salary produces a false capacity, and the bank will correct for it regardless.

Take an example we will carry through the whole article: an industrial SME or startup with €4M in revenue and a normalized EBITDA of €600,000. It is this figure, not the €250,000 net profit, that anchors every ratio below.

The key ratio: net debt to EBITDA

The first ratio banks and investors look at is net debt divided by EBITDA. Net debt is the sum of your financial liabilities (bank loans, leases, financial shareholder loans) minus your available cash. The ratio tells you, in years, how long it would take to clear the debt if every euro of EBITDA went towards it.

• Below 2.0x: comfortable. You have room to invest or absorb a shock.
• Between 2.0x and 3.0x: reasonable for most stable SMEs and startups, as long as cash flows are predictable.
• Between 3.0x and 3.5x: stay alert. Acceptable only for highly recurring revenue (rents, subscriptions, long term contracts).
• Above 3.5x: under strain. The slightest slowdown leaves you struggling to meet repayments.

In our example, with €600,000 of EBITDA, net debt of €1.2M gives a ratio of 2.0x: comfortable. At €1.8M it climbs to 3.0x, the reasonable limit. So the extra €600,000 of credit only becomes a problem if the existing net debt is already high.

The test that really matters: debt service coverage

The debt to EBITDA ratio measures the stock of debt. But what tips you into default is not the stock, it is the inability to make the installments. Hence a second, far more practical test: the debt service coverage ratio, or DSCR. You compare the cash available to service the debt with the annual repayments of principal and interest.

Available cash works out like this: normalized EBITDA, minus the tax you owe, minus essential maintenance investment (renewal capex, not growth projects), minus the change in working capital. That is what is genuinely left to repay with. A healthy DSCR sits above 1.3x. Below 1.2x you have no cushion left, and the bank will often ask for additional collateral.

Back to the numbers. EBITDA of 600,000, minus 80,000 in tax, minus 120,000 in maintenance capex, minus 50,000 of extra working capital, leaves €350,000 to service debt. If a €600,000 loan over 5 years at 4% costs around €135,000 a year to repay, and the existing debt already costs €150,000 a year, the total service reaches €285,000. The DSCR comes out at 350,000 over 285,000, or 1.23x. It holds, but with no margin: one bad year and you slip below the line.

The right question is not "how much does the bank want to lend me?" but "how much can I still comfortably repay in a year with revenue down 20%?"

The stress test most owners forget

Running these ratios on your best recent year is the classic mistake. Debt has to be repaid in the hard years too. Before you sign, run the calculation again on a realistic stress scenario: revenue down 15 to 20%, with margin contracting because your fixed costs do not fall as fast. If the DSCR stays above 1.0x there, the debt is sustainable. If it drops clearly below, you are borrowing on your best case and betting that nothing goes wrong.

Think too about the covenants the bank attaches to the loan: a debt to EBITDA cap, a minimum DSCR, sometimes an equity floor. A breached covenant, even for a moment, can make the whole debt immediately repayable. Negotiate headroom on these thresholds at the outset. It is far harder to win once you are already in difficulty.

Match the debt to the nature of the asset financed

A common sense rule that is broken all the time: the term of the financing should match the useful life of the asset. You finance a building over 15 to 20 years, a machine over 5 to 7 years, a vehicle over 3 to 5 years. The case I see most often is a machine bought on the overdraft, because raising a proper investment loan felt too slow. What you never do is fund operating losses or a structural cash need with a revolving short term credit. That is the classic trap of the overdraft that never clears. If your current account line never returns to zero during the year, it is not working capital, it is permanent debt in disguise, and it needs a proper structure.

The link with the value of your business

Your debt structure directly shapes what you walk away with on the day you sell. Most deals are done on a "cash free, debt free" basis: the buyer takes over the business without its financial debt, and that debt comes off the price paid. Healthy debt, backed by assets and well documented, comes off cleanly. Badly structured debt, vague shareholder loans, or short term lines that quietly fund operations all complicate the negotiation and put the buyer on edge. Controlled leverage is not just a survival question. It signals the quality of your management, and that gets paid for in the price.

How much debt you can carry comes down to figures specific to your business: your genuinely normalised EBITDA, your maintenance capex, the stability of your cash flows. That is exactly the kind of question a fractional CFO works through with you, and the one we tackle in a diagnostic call. In one conversation we lay out your ratios, measure your real margin, and tell you whether the financing on the table strengthens your business or quietly weakens it.

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